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Where Did All The Long Bonds Go?

February 27, 2005

Is there a worldwide shortage of long bonds? It may seem like an odd question to ask when a host of governments -- from the U.S. to Britain to Japan -- are running huge budget deficits. But it's one that the financial markets increasingly are debating.

And no wonder. Just look at what's happening to the prices of longer-dated government securities. In the U.S., the yield on the Treasury's 5 3/8% bond coming due in February, 2031 -- the longest maturity available -- has fallen about a half percentage point since last December, to 4.52%. In the process, the spread between the higher-yielding bond and the Treasury's key 10-year note has narrowed to just 37 basis points, about half of what it was a year ago. The trend extends beyond the U.S.: The British Treasury's 30-year bond is actually yielding less than its 10-year counterpart. That's highly unusual, since longer-dated securities normally carry higher yields to compensate investors for added risks.

Behind the sudden popularity of long bonds are changes, actual and prospective, in regulations governing pension funds aimed at shoring up their finances and protecting retiree benefits. Those modifications are prompting pension plans to step up their long bond purchases to more closely match the maturity of their assets to their longer-dated liabilities. The rule changes started in Britain two years ago, spread to the Netherlands, and now may be heading to the U.S.

On Jan. 10, the Bush Administration proposed a wide-ranging plan for reforming the way the $1.8 trillion private-pension fund industry operates, including the elimination of a host of regulations that have allowed the funds to legally underestimate the size of their liabilities. If approved by Congress, the reforms could prove to be a bonanza for the bond market. When the Bush Administration put forward similar proposals some two years ago, the Committee on Investment of Employee Benefit Assets surveyed its pension fund members to see how the proposed changes would affect them. The bottom line: As much as $650 billion of pension fund assets could be shifted out of U.S. equities into long-term bonds.

That has hedge funds and other speculators salivating. They have piled into long bonds, gambling that the controversial proposals will be enacted by Congress, which will then force the pension funds to enter the market in force. "There has been a lot of hot money trying to front-run pension plans on the notion they will be forced to buy," says Paul McCulley, managing director at the giant bond-fund manager Pacific Investment Management Co. McCulley, however, thinks such speculation is overdone.

In response to the surge of interest in longer-dated securities, both Britain and France are studying the possibility of issuing 50-year bonds. The U.S. Treasury, in contrast, contends that it has no plans to begin reissuing 30-year bonds. In a move that stunned investors, Treasury stopped selling long bonds 3 1/2 years ago when the government's finances were in better shape. At that time, it argued that the action would save taxpayers money. U.S. corporations have not been so shy. They have recently stepped up their issuance of 30-year securities, says John Lonski, chief economist at bond rating agency Moody's Investors Service (MCO). If the long bonds continue to be in short supply, the Treasury may be forced to rethink its position and join in. New longer-dated debt may be long overdue.